Capital Inflows, Exchange Rate Flexibility, and Credit Booms

24 Pages Posted: 28 Feb 2012

See all articles by Nicolás E. Magud

Nicolás E. Magud

International Monetary Fund (IMF)

Carmen Reinhart

National Bureau of Economic Research (NBER); Peter G. Peterson Institute for International Economics; Harvard University - Center for Business and Government; Harvard University, Harvard Kennedy School (HKS), Belfer Center for Science and International Affairs (BCSIA) ; University of Maryland - School of Public Affairs; World Bank; Centre for Economic Policy Research (CEPR); International Monetary Fund (IMF); Harvard University - Harvard Kennedy School (HKS)

Esteban Vesperoni

International Monetary Fund (IMF); University of Maryland, College Park

Multiple version iconThere are 3 versions of this paper

Date Written: February 2012

Abstract

The prospects of expansionary monetary policies in the advanced countries for the foreseeable future have renewed the debate over policy options to cope with large capital inflows that are, at least partly, driven by low interest rates in the financial centers. Historically, capital flow bonanzas have often fueled sharp credit expansions in advanced and emerging market economies alike. Focusing primarily on emerging markets, we analyze the impact of exchange rate flexibility on credit markets during periods of large capital inflows. We show that bank credit grows more rapidly and its composition tilts to foreign currency in economies with less flexible exchange rate regimes, and that these results are not explained entirely by the fact that the latter attract more capital inflows than economies with more flexible regimes. Our findings thus suggest countries with less flexible exchange rate regimes may stand to benefit the most from regulatory policies that reduce banks' incentives to tap external markets and to lend/borrow in foreign currency; these policies include marginal reserve requirements on foreign lending, currency-dependent liquidity requirements, and higher capital requirement and/or dynamic provisioning on foreign exchange loans.

Keywords: Exchange Rate Flexibility, Domestic Credit, Foreign Currency Loans, Capital Inflows, Financial Regulation, Bank Credit, Capital Flows, Credit Expansion, Exchange Rate Regimes, Flexible Exchange Rates

JEL Classification: E44, E52, F33, F34

Suggested Citation

Magud, Nicolas E. and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Reinhart, Carmen and Vesperoni, Esteban Rodrigo, Capital Inflows, Exchange Rate Flexibility, and Credit Booms (February 2012). Available at SSRN: https://ssrn.com/abstract=2012226 or http://dx.doi.org/10.2139/ssrn.2012226

Nicolas E. Magud

International Monetary Fund (IMF) ( email )

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Carmen Reinhart

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Harvard University - Center for Business and Government ( email )

John F. Kennedy School of Government
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Esteban Rodrigo Vesperoni

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University of Maryland, College Park ( email )

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